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Lessons from the National Bank of Romania for the National Bank of Russia

Throughout 2007 and most of 2008 I made many presentations to clients on the short term to medium term perspectives of the Romanian economy. My view was well known to local authorities and clients: the twin deficits spelled trouble. In particular I was warning about a fall in the Romanian currency value. I remember a specific meeting in August 2008 with group of clients in London. At some point they asked me why I think that the currency would depreciate because everyone knew that the central bank would intervene to defend the local currency. I agreed. The conventional view was that the Romanian central bank would not allow the RON to depreciate. But the question was more specific. My estimate was that the EURRON exchange rate would reach 4 RON per euro by the end of 2008. Why was this a problem in their view? Mainly because the NBR communicators have expressed many times the view that the EURRON exchange rate will never reach that level. My answer was simple: NBR will slowdown the depreciation but it cannot afford to fight a sudden capital flight via higher interest rates as it would kill the economy. I was wrong. The NBR did just that.

What happened?

Right after the fall of Lehman Brothers spreads started to increase in the international markets. At about the same time pressures started to build on the RON to depreciate as business in Romania (not just banks) started to use their local resources as cheap source of funding for other places or even headquarters. The central bank’s interventions to slowdown the depreciation were very well captured by the developments in the interest rates on the money market. As the exchange rate approached the level at which the NBR intervened last time to defend the currency, 3.7, the interventions become more aggressive. As the interventions were not sterilised the interest rates kept increasing capturing the lower level of liquidity in the money market.

However, this time the NBR decided not to defend the 3.7 level and let the market push the currency higher towards the 4 RON per euro level. Still, it did it in its own terms intervening along the way pushing interest rates higher and higher. At the 3.9 level the NBR (which has publicly announced before that the 4 level would never be achieved) intervened aggressively to stop the RON depreciation. But this time was different. During previous episodes the central bank was able to push the exchange rate lower via intervention without much resistance. This time the cost was approximately 4 billion euros from the reserve and as the central bank did not sterilise its interventions it meant a shortage of around 16 billion RON from the money market. And still did not stop the capital flight. Interest rates moved above 100 percent in the money market and traded at 1000% in the swap market. This was not enough either. There was still a large flow of RON that expected to be exchanged in euro and exit. The NBR did the last thing they could do: imposed implicit capital controls. It called local banksand asked them not to trade with foreign counterparts. No matter the price, the RON was not available for foreign counterparties. Without access to RON in their accounts foreign parties could not exchange for euros and exit. The exchange rate stopped at 3.9 ron/euro and fell to 3.5.

Finally, in order to hide the high interest rates in the money market the NBR passed a rule that publicly announced interest rates, ROBID/ROBOR, could not be higher by more than 25% than the Lombard rate. All of this developments took place in one month, in October 2008. And it happened because the central bank misunderstood the reason for the depreciation. It thought all along that it faced a speculative attack when in fact it was capital flight, return to safety, need for funding, etc… That is why the flows did not respond to any dose of the medicine administered by the NBR – higher interest rates via interventions that withdrew ron liquidity in the market. Yes, this is the right thing to do when there is a speculative attack on your currency but the worst thing to do when you face real money exiting your economy. In the second case the higher interest rates do not help as the ones exiting are only interested in the exchange rate. They already know that they want to leave. Furthermore, attempts by the central bank to strengthen the domestic currency act as gasoline on fire for those that are ready to leave – a stronger domestic currency buys more hard currency.

The aftermath

The economy went into the hardest and deepest recession since 1989. Right in that quarter – 4th quarter 2008. The government was short cash as companies did not have RON to pay their VAT or other taxes to the state. Basically the NBR actions cut off the financial market from the rest of the economy. The only thing happening was that banks would borrow liquidity for one day from the central bank to cover their deficit and the government would borrow via deposits for up to two weeks to keep its day to day business running. That was it.

Interest rates for existing and new credit, in both household and corporate market, increased towards 20% from levels close to 10%. This meant the death of the credit market. Now, 6 years later is still being resuscitated. The only sector of the credit market showing signs of life is the one representing 3% of total credit: credit in domestic currency for housing subsidised by the government.

Furthermore, banks recalled short term credit lines from companies and did not extend new credit. In December 2008 companies could borrow short term from banks at interest rates close to 30%. These were the interest rates in the money market used by banks to fund each other. They were not seen by the public due to the new central bank rule. Thus the market was trading at interest rates close to 30% while the public would see interest rates around 18%. And the situation continued to be difficult for months to come. The central bank only started to inject liquidity via REPO operations in March 2009. Until then it brokered a deal with the IMF to increase the FX reserves and the Vienna Accord – banks agreed not to repatriate any money during the accord (banks managed to repatriate 2 billion euros from October 2008 to February 2009). Only after those deals were signed the NBR felt comfortable to inject liquidity in the system but it was too late and the damage was already done.

The measures taken by the central bank in 2008 and 2009 only postponed the inevitable. In 2012 when banks were freed from the Vienna Accord they continued the repatriation of profits. Since then another 8 billion euro have left the banking sector. In 2008 the banking sector had 20 billion euro in intercompany loans to finance operations in Romania. Today it has only half of that amount.

Bottom line

The National Bank of Romania treated an outflow of real money as a speculative attack and the Romanian economy paid a hefty price. In fact some of the effects are still felt today, especially in the transmission mechanism. The National Bank of Russia is doing the same thing – using interest rates to fight what it seems to be an outflow of capital due to fundamental reasons and not all related to Russia. It is the wrong tool for this job as the Romanian experience shows. So far the effects of the policy are as expected: the currency continued to depreciate and the economic growth has slowed down. The only good thing is that Russia, unlike Romania, did not implement all those drastic measures in one month. That is why the effects took some time to appear. But the latest increase in the key rate to 17% has the potential to speed things up on the road to perdition.

There is only options left for the NB of Russia. It can try to slowdown the depreciation while sterilise its interventions – keeping the money market liquid. The exchange rate will be relatively stable but it will lose reserves. However, the banking sector and the economy will be spared and will be able to function. When the dusts settles having a functioning banking sector and a working economy is oath much more than a huge reserve of hard currency at the National Bank of Russia (Romania).

A study on the NB of Romania response to the OCtober 2008 outflow is here